Bankers and Externalities Galore

Ah! A teachable moment.

As a matter of fact very many such moments. How does the continued existence of the big banks act as a disproof of free market theory?

A cursory familiarity with the news shows us plenty of examples of what economists call “externalities”. These are pernicious events that fall outside the set of events that orthodox economics can explain. The disaster imposed on the world by incompetent bankers and the environmental disaster unfolding in Hungary are just two examples.

The point with an externality is that it is an event orthodox economics has no way of including using its normal methodology. This is because that methodology relies on the incentives that flow from private ownership of property. Economists use private property as the bedrock of their entire explanation of the economy’s workings. The interplay between supply and demand is based upon freely associating individuals who have complete knowledge of prices and have total control of the resources they are exchanging. Since they own the stuff being exchanged they bear the consequences of the transaction. So economists suppose that this ownership will induce rational behavior. In other words economists assume that people will behave rationally because they have to face up to the profit or loss of transacting – no one else is responsible, no one else bears a cost.

But this is a limited and flawed view of the real world. We all can easily rattle off events where the consequence of a transaction or event was borne by someone other than the owner of the property involved. The recent banking crisis was created by stupid bankers making dumb trades oblivious to their consequences. One reason for their stupidity was that there was no incentive within the system for them to wise up. They knew that they could screw up and not have to pay a related price. The taxpayers picked up the tab for the incompetence and selfishness of the bankers who, by and large, escaped scot free. Even those bankers who lost jobs never paid the full price of the damage they inflicted on society: they are not the ones paying for the unemployment checks being mailed out by the millions each week. Yet their actions are the root cause for those checks being mailed.

Similarly, in Hungary the company whose dam burst and flooded an entire town with toxic sludge is not going to be the sole source of compensation and or only group to bear the clean up cost. Society at large will, inevitably, be involved.

This is why those who defend free markets are living in a dream world. The defense of a free market system relies entirely on the smooth operation of an incentive structure for the actions of individuals. In the magical world of a free market such incentives induce behavior that sums up to benefit social welfare. The whole benefits from the greed of the individual. This is the logical end point of Adam Smith’s “invisible hand”. For Smith’s vision to play out in reality, rather than be a metaphor, the economy must be all inclusive. It cannot have externalities. The notion that private actions have public, and not exclusively private, consequences destroys the theory before it even gets going. The logic dissolves.

There have been many attempts to jig the theory by kluging on addendum bits and pieces to account for externalities. But they all fail. The free market system stands or falls by being entirely private with entirely private incentives driving entirely private consequences. Externalities undermine the logic and allow – indeed they ensure – anti-social outcomes will arise from private exchange. Where the consequences of private actions leak into the public domain free markets theory collapses and fails to explain or predict what’s going on in an economy.

This is harsh, of course. Defenders of free markets will point to the mountain of literature written describing the results of externalities and other “market failures”. Theorists have devoted miles of ink to descriptions of such failures. That’s all well and good. Perhaps they would have been better served expending that energy and time on developing a theory that included, rather than excluded, such events. You know: a theory based on the real world.

Meanwhile we rely on the kluges to help us develop policies to offset the exploitation of externalities by private entities like GE who dumped waste into the environment for decades, never bore the cost, and thus handed unearned wealth to their shareholders for years. GE was safe in its knowledge that it trashing of the environment as creating costs it would not have to account for in its income statement. The profits it reported were thus inflated by that omission. Its stock price rose way beyond it true economic value, precisely because economics had no way of making it include those costs.

Likewise bank stocks were wildly overstated during the run up to the recent crisis because they failed to account for the losses inherent in the anti-social investments being traded and gambles with on Wall Street. The traders who created those losses are now reaping huge personal gains in the form of record bonuses because the taxpayers have underwritten their renewed gambling.

The common theme throughout this story is that we have an economy where private gains and public losses are often – too often – associated. Any market driven system suffers from this fundamental design flaw. Societies offset the flaw by imposing regulatory costs, hopefully sufficient to induce socially beneficial behavior. But in societies like ours, where money buys influence, it is always possible for those who benefit by damaging society, to protect themselves from bearing the full cost of any externality they wish to impose on the rest of us. Pollution is rarely punished to the full extent of its social cost. People who gain by polluting are thus earning unwarranted or anti-social profits, or “rents”, at the cost of society as a whole. Not all pollution is environmental. The banking crisis was also a form of pollution.

The trick when dealing with polluters is to reduce their ability to earn those excessive rents. Make them pay. Had we succeeded there would be far fewer bankers, and those left would be a great deal poorer than they are. That they still exist, and that they still pollute, is evidence of the failure of free market theory.

As they say in math: Quod Erat Demonstrandum. QED.